My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Thursday, December 18, 2008

To zero..and beyond...

Day before yesterday, the Fed announced that is was cutting the Fed Funds rate close to zero. In the weeks preceding, the three-month US treasury bill rate has flirted with negative yields... Both phenomena raise a question: Can nominal interest rates become negative?

Let us start off by accepting the fact that real interest rates can become negative and have, for extended periods in the past. Real interest rates can happen when expected inflation is high but central banks decide to flood the market with enough funds to keep nominal interest rates below the expected inflation rate. However, a negative nominal interest rate is not only unusual but difficult to grapple with. As my sixteen-year old put it, why would someone put their money into an investment to get less in three months than they invest today? Why not stick the money in a checking account or even under the mattress for that period?

For small amounts of money, nominal interest rates should never fall below zero, because either the checking account option and the mattress option is viable. But what if you are a portfolio manager or a corporation with $ 3 billion in cash? Holding the cash balance as currency in your corporate headquarters is an invitation for the heist of the century (Think Oceans 11, 12 or 13..) Putting the cash into a bank account is not completely secure, because the FDIC protection works only up to $250,000.... If the bank goes under, your principal is at risk. In normal times, we would not consider this a likely scenario but we are not in normal times.

Both the Fed move to cut the Fed funds rate close to zero and the short term treasury bill rate dropping below zero are indications of how much investors have lost faith in the banking system. Large investors are in effect saying that they would rather accept an -0.5% nominal interest rate than risk leaving large amounts of cash in a bank. That is not only astounding but scary.

13 comments:

I agree it's scary and I think it will get worse considering the Fed's recent actions. The risk of liquidity trap combined with explosion in the monetary base is now greater than ever. Back to the issue of negative nominal interest rates. If we assume that investors have deflationary expectations (at least in the short term), this means that real interest rates can still be positive, doesn't it. And real returns is what really matters.

......I remember asking you a question on this sometime back.Should the Rf be necessarily anything more than expected inflation? If we assume a no inflation economy, should there be a positive Rf at all? You had said that there should be a premium for forgoing current consumption for the lender and so there should be.

But now if you are scared of keeping the money (i.e, excess money over and above your consumption) under the matress or in a bank for the fear of losing it - then you wouldn't be demanding a compensation for forgoing current consumption right? Infact you might even be willing to pay a premium to safeguard your money, isn't it?

For investors to give up current consumption for future consumption, you will generally need to offer a real interest rate, especially for longer term borrowing. That cannot be changed just because we are in crisis.

The Bank of Japan has followed suit cutting the reference rate to 0.1%. However they have done it before, their effective interest rate was zero from 2001 to 2005. The US$ and Yen has become the most coveted currencies to borrow in "carry trade". The risk free rate is at an all time low. The equity risk premium and the Default Risk premium are at an all time high. Sooner or later they will move towards their 'normal' values. I suspect that the risk premium and the DRP will fall before the the Risk free rate moves upward. The hurdle rates for corporate projects will start heading down. The banks would be tired of hoarding cash and start lending. The funds that are sitting on cash would start investing in equity markets. A very optimistic view...but this is inevitable- sooner or later.

I don't understand one thing. The negative yields will be if an investor sold the bills earlier than the maturity date has come. I know that treasuries are used like quasimoney but still You are talking about huge portfolio and the situation when such an investor must sell all treasury bills immediately is very doubtful, Maybe I am wrong...

Treasury bills don't carry a coupon. They are instead sold at a discount on face value and the interest you earn comes from moving to that face value. For the first time in history, treasury bills were sold at a premium on face value. In effect, investors were paying $1002 for the privilege of receiving $ 1000 in three months.

Credit spreads are out of control. A AAA GE bond of 3 years maturity is yielding about 5% right now, but a BBB corporate bond of the same maturity is now yielding 20%.

Are we really to believe that the spread between AAA and BBB bond is 15%??? And mind you, AAA is then what, a clear 1.5% above the Risk Free Rate. So does that imply that the equity premium above the risk free rate is something like 16.5% for a just-barely investment grade company?

It seems insane to me. Bonds come before equity. If we are really to believe a BBB rated bond can yield 15% above AAA, what does that say about the equity risk premium.

Even if forward rates don't reflect interest rate parity, I still wonder if this carry trade is possible in the current scenario. Though fed is cutting rates which is also driving the LIBOR rates down, the credit spreads have widened so much for any counterparty to be able to execute this arbitrage. Also I have a serious doubt on the authenticity of LIBOR rates quoted in the market anyways? Would banks be wiling to lend each other at such low rates in such a high counterparty risk scenario??? Infact at one stage LIBOR rates were lower than Fed Auction rate!!!!

Prof - You have raised a valid question but i think the answer needs to be more detailed out on 2 aspects - a) implication, if it happens b)what are the chances of this happening...

though point (a) has been touched , but more interesting will be economist point of view on this -- how will this impact consumption patterns, how will this impact economy (Will Stagflaton be a possibility then). Imagine disastrous impact, if will have on banking system as retail deposits will be sucked out of financial system

more importantly what are the chances of this happening it can come to zero but why would regulators make it negative.